Credit Torrent

2010 February 26
by Dave

Banking is dead. The bankers just haven’t noticed yet. Forget restructuring the regulatory framework of the global financial industry to insure that there will never again be systemic risk caused by entities that are too big to fail. Finding the sweet spot where a credit intermediary is large enough to mitigate individual risk to an acceptable level but small enough to not aggregate so much risk as to be swamped by correlated market movement is impossible.

A lot of very smart economics phd candidates will be inspired to make these systemic risk issues the topic of their doctoral research. The answers are rooted in simple pre-algebra and won’t take any fancy mathematical models to explain. They will just be technically difficult to implement.

The amount of risk to a single creditor posed by the default of a single debtor decreases as the share of the creditor’s capital at risk to the debtor decreases. Thus, infinitely small chunks of an institution’s capital could be lent out to an infinite number of borrowers at no risk. Unfortunately there is a lower bound on the amount of individual loans so the only way to decrease this kind of risk is to increase the total amount of money being lent. Thus the larger a bank, the less risk an individual default poses to individual depositors.

However, systemic risk is minimized as borrowers are paired up one to one with creditors because then the default of one borrower only hurts one creditor.  Minimizing individual risk and minimizing systemic risk are at odds. The two will always pull against each other with the balance moving back and forth based on political climate and the intensity of memories of the most recent calamity.

However there is already a model that finds one of the combined minimums. Think about the benefits of lending through a bit torrent feed. Individual lenders would have their capital sliced into the smallest transmittable chunks, thus bringing their capital at risk to an individual borrower to the minimum achievable without aggregation which maintains a one to one link between borrowers and lenders. Applying variable interest rates that reflect current system wide default risks, individual default risks, and system wide liquidity would allow the price of credit to reach it’s natural level.

The main flaw with such a system is that it would be pro-cyclical. But the current system is pro-cyclical as well. This would at least unhitch governments from credit risk and allow them to manage the business cycle through monetary, fiscal, and tax policies.

I’m not saying that this is how things will end up. I am saying that the big structural bits of capitalism are do for a technological upgrade on par with the one already received by the surface bits of capitalism that comprise investment banking. Or maybe I am on to something and your next credit card will be issued by the pirate bay.

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